2018 q4 highlights.png

An apt description for 2018 might be “Be careful what you wish for.” It was a year that began with great promise and optimism but ended with disappointment along with a healthy dose of anxiety. In January, the change in the tax law was expected to generate higher economic growth than had been experienced over the prior several years. In fact, GDP growth did accelerate, wages, especially for lower income households, began to rise meaningfully, unemployment is now at a 50-year low, the Federal Reserve continued its normalization of monetary policy, and the outlook for corporate profits is strong. So, why is the stock market behaving so badly? To state the obvious, stock prices react to what investors think will happen rather than to what has happened. Fear and greed still rule the market, at least in the short term. When there is little to fear, investors don’t want to miss out on future price increases and are content as they pay higher prices to own good (and sometimes bad) companies. When the future becomes less clear, or the news becomes filled with negative stories and data points, fear and more cautious behavior returns. It is a natural human behavior to take both fear and greed to excess which in the investment world can be observed by price volatility and flow of funds.

Volatility, seemingly absent for the past couple of years, has returned. Volatility is “a tendency to change quickly and unpredictably” per Merriam-Webster. The Oxford Dictionary adds “especially for the worse” to the foregoing.

2018 q4 volatility.png

This deviation in price change is a standard measure of risk in the investment world. But how accurate or important a measure is it? For traders and short-term investors, it is certainly important. For the long-term investor, it is not—or at least it should not be a primary concern. The two greatest risks for a long-term investor are loss of purchasing power and maintaining one’s life style. If one must sell at a specific point in time, volatility is clearly the major risk. If one has no intention of selling in the near term, does today’s stock price really matter? A company’s financial soundness, dividend paying capacity, future growth possibilities and cash flow measures do matter. It is only human to be happy to watch one’s portfolio increase in value month after month and to be somewhat depressed, nervous or even scared when values decline, especially when it happens rapidly and unexpectedly. The rational logic of “if you liked the stock at $100 per share, you should really love it at $50” gives little solace to most people. Yet, successful investors push emotion aside and focus on the reasons that they invested in the company in the first place. Understanding a company’s operations in terms of what it does, who it sells to, who it competes with, what its goals are and especially what are its weaknesses gives a long-term investor comfort that their investment case is still intact despite what the market says the company is worth.

Understanding the financials, analyzing cash flow to gain some assurance that management is running the company with shareholders in mind, and having a high degree of confidence that the company will prosper during the next several years are key to a successful investment. Volatility, caused by traders, the news of the day, or just nervous investors does not impact how a company operates day to day. But for the long-term investor, volatility can be an opportunity to buy when others are selling, or to sell when others are buying.

Fund flows into or out of investment sectors can also cause prices to rise or fall. It is simply a matter of supply and demand. Economics 101 teaches us that price is the balancing mechanism between the supply of something and the demand for that item. Scarcity creates higher prices and conversely a glut drives prices lower. The Flow of Funds chart tracks money being invested in or being liquidated from equity mutual funds over the past 15 years. It does not track all money flows in the financial markets, but it does serve as a proxy for how investors felt about investing in the stock market. As can be seen, the S&P 500 Index rose during times when investors poured money into the market and fell when monies were withdrawn.

2018 q4 flow of funds.png

The flow of funds is only one tool or indicator for the direction of the market and may not be the best way to time the market, even if successful market timing were possible. Flow of funds is probably only a coincident indicator at best, and more likely a lagging indicator, since it measures actions taken by investors after they have become fearful. The problem with becoming too fearful too late is that one is “selling low and buying high” instead of the reverse. In fact, past studies have shown that investors in the aggregate have actually realized less than 4% annual returns on their stock market investments instead of the roughly 10% annualized return of the always-invested S&P 500 Index.

2018 is now over and we must look forward to 2019 and beyond. A year ago, most investors and market strategists, including ourselves, expected 2018 to be a positive year for stocks even with the Federal Reserve raising short term interest rates throughout the year. A recession was not expected and did not occur. The S&P 500 Index declined 4.4% and 3-month US Treasury Bill rates increased from 1.4% to 2.4% while 10-year US Treasury Note rates rose from 2.4% in January to 3.2% in November before falling back to 2.7% at year-end. US GDP growth was much stronger than expected but as the year wore on, the trade war with China was recognized as having the potential to hurt future domestic growth and to possibly derail global growth, especially in China—the second largest economy in the world.

As we enter 2019, the world is faced with a higher level of uncertainty than had been the case just a few months earlier. The long, albeit patchy period of expansion is showing signs of fatigue and central banks are moving away from their easy money policies. Purchasing managers at manufacturers worldwide are nervous about the outlook for orders. Trade talks with China will continue to heavily influence market sentiment and the Federal Reserve’s intent to raise rates at least two more times adds another headwind. Other potential headwinds include Brexit, the European Central Bank’s intention of ending its bond buying program, and some recent weakening data regarding retail sales and industrial production. Despite these worries, there are also many positives. Corporate earnings growth is still strong, even though it will be decelerating from its 2018 pace. Both the recent growth in jobs and especially in wages have been surprisingly strong. Banks are in the best financial shape that they have been in for decades. Corporations are no longer trying to move offshore for tax reasons and jobs are returning to the U.S. from overseas. Higher interest rates are giving investors an opportunity to generate higher returns on their cash and bond investments.


It is important to stay focused on the ultimate investment goal or goals and not let emotion overtakesound analysis. Understanding true risk is important and having the knowledge that one’s assets are invested for an all-weather environment can bring comfort and calm at times such as this. Asset allocation can be envisioned as separating investment funds into different buckets, each of which will have a different goal. A simple example is three buckets: cash, bonds and equities. The goal of cash is to provide safety and be the source for near-term cash flow needs. The bond bucket’s goal is to be a safety valve for unexpected cash needs. The characteristics of a bond portfolio are that it provides higher income than cash but is much less volatile than stocks. The equity bucket’s goal is to protect future purchasing power and lifestyle. Allocations to cash and bonds can also be considered as the “sleep-at-night” funds. Stocks have and should in the future provide the highest returns over the long term, but they are also subject to more emotion and volatility. Finally, our outlook for the financial markets for 2019 is positive, but with a recognition that challenges face us. Our bond portfolios are invested primarily for safety in a rising interest rate environment and our equity portfolios are invested in individual companies where we have a high degree of confidence in their fundamentals and future prospects. As we mentioned above, we push emotion aside and judge companies on their merits, not letting market volatility dissuade us from our investment case. Given that stock prices have declined very sharply in some cases from their peak levels a few months ago, we believe that equities are a much better value now than then.


“Don’t put all your eggs in one basket” is a familiar maxim in investing. Diversification is a time-tested method for reducing investment portfolio risk. Ask anyone who was invested in the well-known Sequoia Fund over the past 5 years whether they believe it was wise for almost 25% of the fund’s assets to be invested in a single stock which lost 97% of its market value at one point (Valeant Pharmaceuticals). Do so, and you are likely to get an earful. We limit the size of individual positions as one of several risk management tools at our firm. But are there times when diversification taken too far can work against investors’ goals or expectations?

We believe the answer is yes. Diversification takes many forms. It may relate to the number of individual securities held in a client account. For example, a single mutual fund typically owns 70 to 120+ stock positions, thus being in half a dozen funds is the equivalent of owning hundreds or even thousands of individual securities. Types of diversification could also refer to the number of asset classes (stocks or bonds or commodities), or sectors (technology vs industrials) or market capitalization (small vs large) or geographic areas (US vs Emerging Markets). In many instances, it refers to the number of outside managers or strategies in which an advisor has placed clients. Often diversification can be a dizzying array of all of the above.

We believe strongly in risk control by keeping equity holdings diversified. We also believe in asset diversification between stocks, bonds and cash depending on an individual’s needs and investing time horizon. That said, it’s reasonable for investors to ask if diversification is accomplishing its intended goals. Simplicity, transparency and manager accountability can often be casualties of diversification. This can be true even during market pullbacks like the one in which we are currently. The rationale for investing in diverse asset classes makes intuitive sense, but if your holdings are scattered among ‘funds of funds,’ mutual funds, bonds, private equity funds, real estate funds, Master Limited Partnerships, annuities, gold, commodities, Real Estate Investment Trusts, as well as hedge funds (“alternatives”) it is possible this kind of breadth is not only adding complexity and cost, but also impairing real economic value. Wall Street is good at producing new ‘solutions’ or ‘vehicles’ to protect investors from market ‘volatility,’ however what matters more is whether ‘diversification’ is meeting your personal goals in terms of wealth accumulation. As an example, the chart below provides the trailing 5-year annualized return in various asset classes. We’d note two examples: Bloomberg’s Commodity Index has declined 8.8% per year for the last 5 years while the US stock market has compounded at a positive 8.5% per year. Diversification or opportunity cost? The HFRI Equity Hedge Fund Total Index gained 2.3% per year over this same period. Worth the rich fees charged on principal and capital appreciation? Our main point: ask questions. Sometimes more does not necessarily translate into better.

2018 q4 annualized return.png

We invest a lot of time and effort into fundamental research of the businesses we own for clients. We believe in running concentrated portfolios of approximately 25-35 stocks often supplemented by fixed income holdings where we emphasize credit quality and focus on duration. Why only 25-35 stocks? For two reasons. The first is math: studies have shown that when you have added 20+ stocks from different sectors into a single investment portfolio—you have already captured over 97% of the benefits of risk-reduction through diversification. Simply adding 50-100 more stocks to a portfolio is not guaranteed, nor statistically proven, to improve the benefits of diversification. Secondly, we understand we are putting far fewer eggs into the basket than many peers, but we are scrutinizing each egg for quality and strength at time of purchase as well as monitoring the basket very closely. We believe this approach adds a level of discipline to the investing process that might not be present in a portfolio of say 150-200 stocks and bonds where the typical position size is often 1% or less. What does the 99th or 120th stock position truly add to portfolio performance? Not much. We would not be doing the client any favors by investing a negligible position into a holding we have researched in depth for months. We want our best ideas to be large enough to have material impact on returns. We are human. We make our share of mistakes and our process will not shine in every market cycle, but over time, we’ve made more good than bad decisions and the results achieved tie back to a disciplined process which does not attempt to own a little bit of everything, but instead to focus on what we know best.

Here are two areas we think it is worth being mindful about with respect to diversification:

Complexity: Do you know what you own—or is the amount of due diligence required overwhelming? Is here excessive ‘tweaking’ or positioning of funds/ strategies which are creating additional transaction costs? Is the breadth of what you own increasing your overall investment costs? (i.e. ‘fees on top of fees’ client pays advisor, but also gets hit with mutual fund company fees as well custodial fees as well as perhaps another intermediary’s fees?); is the hedge fund charging you 2% of your principal and 20% of your capital appreciation earning its keep? You’ve likely heard the old saw regarding how your ‘investments are like a bar of soap, the more you handle them, the more they seem to disappear’? We believe there is some truth to this in instances where client funds move often and rotate between strategies or funds or asset classes.

Investment Performance: Do you understand the investment return implications of the level of diversification chosen for your assets? Example: is a 5% compound annual return over 10 years in a dozen different investment vehicles/strategies comparable to a 12% compound annual return in a single strategy — or is it a reasonable return based on the risk profile of the investments selected? Is the opportunity cost of not compounding at 12% relevant to you in 10 years or is it more important to feel ‘protected’ regardless of whether your returns don’t keep pace with inflation?

Ultimately, the questions which we believe should matter most: is the strategy understandable? Is it time tested? Is it repeatable? Is it attached to a human being who can intelligently explain it?

As long-term investors, we believe a low turnover, concentrated approach to equity and balanced accounts is the best approach for compounding wealth at an attractive rate over time. Our view is straightforward and one that non-professional investors understand and can embrace: that view is that most would prefer a pool of assets to be worth as much as possible at some point in the future. Diversification across and within asset classes can be an effective tool in managing risk, however, investors should be mindful of whether it is helping achieve personal goals and objectives over time.


During periods of volatility in the markets, we often ask our clients whether or not losses in their investment portfolios are causing them to lose sleep. Our goal is to understand if the losses are triggering “fight or flight” responses in their nervous systems. If investors are sleeping poorly as a result of decreases in wealth, it indicates that this instinctual system has been activated.

2018 q4 sleep test.png

Over the millennia, our brains have evolved to adapt to changing environments. Humans have different neural networks or systems which deal with different sets of challenges. The prefrontal cortex is the section of the brain which controls higher level reasoning and is referenced in Daniel Kahneman’s work (see Thinking, Fast and Slow) as System 2. It is the brain network activated when multiplying numbers in your head or trying to solve a difficult crossword puzzle.

Another system at work is Kahneman’s System 1. This network handles tasks such as browsing instant messages or driving. It processes large amounts of information quickly based on neural pathways that have been formed over the years. This area also allows us to make lots of decisions without expending too much mental energy.

Finally, there is another much older area of the brain involved with threat detection. This area is the limbic system. The limbic brain alerts the body to threats and is involved with flooding the blood stream with stress hormones such as Adrenalin and Cortisol which prepare the body to fight or run from actual or perceived threats. The limbic brain is very useful if one is attacked in the subway or needs to flee a natural disaster.

Money and wealth trigger many different brain centers and systems. Ideally, investment decisions are made rationally where the prefrontal cortex is involved in deep System 2 thought. Different options need to be weighed including factors such as the time horizon, return potential and risk of the specific investment. Correlations between investments and how a portfolio will respond to different economic or market conditions should also be considered.

Many investment decisions, however, are made through the System 1. These decisions are less than ideal since biases influence the decision-making process and investments are chosen by rote. However, automatic thinking is superior to decisions made with the primitive limbic brain.

Aside from its utilitarian value, money is also associated with feelings of safety. Having wealth sometimes provides a sense of comfort that the assets will be able to protect one against life’s dangers. When the market falls, the limbic brain often sends signals that the investor is being attacked and needs to do everything to protect her or himself by selling all risky assets and going to cash. These decisions are rarely rational and often lead to poor outcomes.

Our goal with clients is to invest their portfolios in stocks to the level of risk that they are able to handle during more stable markets so that the “fight or flight” response is not triggered during volatile times. We believe that the innocuous question “are you sleeping at night” is an important test of keeping the limbic brain at bay.

2018 q4 conclusion.png